Educational Articles

The Divergent Business Models of the Internet

Reuben Gregg Brewer
| July 08, 2010

There have been a number of business models built around the Internet. At first, the model was to charge people for access to a controlled web world, which made AOL (AOL) a very profitable company for many years. That model stopped working when higher quality content and services began to spring up elsewhere, often for free.

Content was, thus, divorced from Internet access, which telecommunications companies like Verizon (VZ) and AT&T (T), and cable companies like Time Warner Cable (TWC) and Comcast (CMCSA) now dominate. This led to the ill-fated and recently reversed “merger” of AOL and Time Warner (TWX), as well as high-profile companies dropping the portal concept, such as Walt Disney’s (DIS) Go.com, which is now a shadow of its former self.

The most obvious model, retail sales, is the only model that hasn’t changed materially. For example, retailers like Amazon.com (AMZN) still make money the same way—by selling things. That said, the technology used in the process has upgraded materially and formerly brick-and-mortar stores, like retail behemoth Wal-Mart (WMT), have entered the fray. This has upped the ante for web-only retailers and weeded out some of the weaker concepts, such as Pets.com, which folded in the technology bust of the early 2000s.

Now almost every major retailer has an online store in addition to its normal sales outlets. This list includes catalog and television retailers, such as HSN (HSNI) with its Home Shopping Network. The retailing model is likely to remain fairly steady, with back-end technology the biggest factor facing change. However, the barriers to entry are exceptionally high at this point, limiting future competition from new entrants, but increasing competition between current participants.

Another model that has taken shape of late is a social model. These sites offer a place for individuals to congregate and communicate, which creates a center of gravity for information. The entire model is based on getting more people to come and “join in.” Message boards were the original gathering places in this model, but technological advances have vastly enhanced what were once just a list of text messages. The current giants in this field are social networks like Facebook, MySpace, and, more recently, Twitter—which appears to be changing the way many people communicate.

MySpace is owned by media conglomerate News Corp (NWS). Rupert Murdoch, who heads News Corp, has been a major proponent of charging web users to view content, such as the company’s Wall Street Journal online offering. While this may work for professionally created content, it is unlikely to work for a website that is only valuable if people use it as a congregating point. Thus, constant news of Facebook and MySpace charging is likely overblown. The more likely source of income for these sites is advertising revenue and the sale of services.

Advertising on these types of sites has been a contentious issue. While lots of eyeballs is a great reason for corporations to advertise on a site, the functionality of these sites allows for much more customization based on the plethora of information that Facebook and MySpace know about their users. The only problem is that users generally don’t like their private information revealed to advertisers. The resolution of this conflict will likely include much give and take between the provider and the user. The outcome could be beneficial for both parties, if the right controls are put in place.

Services, meanwhile, are another source of revenue here. One of the biggest growth areas of the Internet recently has been casual games, such as Farmville. The games are simple and, apparently, for some they are addicting. Moreover, gamers seem willing to spend a few bucks for new gadgets within the games they are playing. This makes both the games, which sit on top of social network sites and can generate revenue through the sale of game items, or, higher quality versions of the games themselves, powerful tools for revenue generation. Social network sites either get a cut of the action or bring the games in house to get all of the revenue. It also brings up the possibility of selling other small applications, so-called widgets, that sit on top of the otherwise free sites. But, at the end of the day, charging for the use of a Facebook or MySpace would likely reduce usage so much that the web property would plunge into irrelevance.

Content providers are, perhaps, at the biggest crossroad when it comes to the web. When the Internet first started to become a mainstream communications medium, the concept was to get people to a website at any cost. As a result, many content providers gave content away for free. However, this move has proven a poor choice, as web users are now used to receiving free content that would once have required a subscription. The original thought of subsidizing the free dissemination of information with advertising simply hasn’t worked.

Some companies, such as Playboy (PLA), have been changing their business models and embracing web and video media distributed through the web and other venues. Other, more mainstream, content companies, such as The New York Times (NYT) have flirted with several different pay models without any resounding success. News Corps’ Wall Street Journal offering has been one of the few subscription successes on the web, but the site could hardly be called a major triumph for the content model. The companies that fight with the content model are many, hailing from the newspaper, magazine, video, and music industries, among others. There is no easy answer here and the battle not only includes free versus paid for, but also pirated versus legal.

One leader in this space is Apple (AAPL), which has taken its iTunes store from a retailer of music to a retailer of virtually every form of content. The company’s strong link between the products through which content is consumed (iPhone, iPad, iPod) and the copyrighted content is one of the major reasons for its success. Others, such as Amazon with the Kindle ebook reader, are trying to replicate this success, but they simply don’t have the breadth of content or the established tie between content and product that Apple has created.

Both Apple and Amazon, however, have had to deal with the push back from the actual owners of the content that they are selling—as the content owners have not been happy with their “cut of the action.” Battles of this type are likely to continue and could escalate if a serious competitor to Apple’s iTunes store can be cobbled together by competitors. Amazon appears to be the most capable competitor here, but it has yet to bring its model to the level of Apple.

When one considers content, search engines such as Google (GOOG) and Yahoo! (YHOO) inevitably come to mind. Interestingly enough, however, Yahoo! has outsourced its search functionality to Microsoft (MSFT), with its new Bing technology. This has left Yahoo! as a content aggregator and, more recently, creator. This is a shift that AOL has been pursuing more aggressively, too. The idea harks back to the capture of more eyeballs by giving away free content concept of the early web. This may cause some of the traditional media companies additional pain, as customers’ expectations for free are met by competitors without the legacy costs of non-digital products and operations.

The move for Yahoo!, however, doesn’t completely undermine the revenue it generates through search advertising. In fact, both Google and and Yahoo! are looking more and more like advertising agencies that happen to provide a free service to retail customers. Indeed, these two firms, as well as Microsoft, have been snapping up small web advertisers, in many cases for years, to gain both customers and the technology that they hope will drive future revenue growth. That said, Google, in particular, has been creating new products and services for years without yet creating a viable long-term complement to its search advertising business. The same holds true for Microsoft, though its efforts have been more successful in some respects, as witnessed through its dominance of Internet browsers (though it should be noted that it gives this product away for free).

Web retailer Amazon.com, interestingly enough, has probably had the most success in branching out from its core franchise, as it has embraced so-called “cloud computing” by offering up its servers to others. Thus, customers are buying processing time as a service in small and easily adjustable increments. This builds on the company’s knowledge in operating its own servers and allows it to capitalize on investments that might otherwise sit idle. The retail business is, and will likely remain, Amazon’s core focus, but as a side business, “cloud computing” is definitely a management success story.

It is difficult to pinpoint which business models will succeed on the web over the long term because of the heavy ties between consumer taste and technology. That said, advertising will always be needed, which suggests Google and Yahoo! may have sustainable web businesses in line and, arguably, tied in with the likes of the retailers. That said, the adoption of new technologies, such as web enabled phones, can quickly throw what appears to be a stable situation out of balance.

At the end of the day, investors need to avoid the hype of the Internet, particularly in light of the devastating technology crash in 2000, and ask “how does this company make money.” By doing this, the focus is shifted out of the conceptual world and into the real one. If understanding how money will be made requires a leap of faith, there are probably better options available.